Making Sense of the Federal Reserve

On Tuesday, with ongoing problems in global credit markets and continued trouble domestically in housing and mortgage markets, the Federal Reserve cut its funds rate (the interest-rate banks charge other banks for loans) half a percentage point or 50 basis points, from 5.25 percent to 4.75 percent. It was the first rate cut by the Federal Reserve in more than four years. Wall Street titans and casual investors alike have been wondering what this decision by the Fed will mean for monetary policy and future economic growth.

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#ad#For a wider view on the implications of the Fed’s decision, I contacted Steve Beckner, arguably the most respected Fed watcher in the country. Beckner has been covering the Federal Reserve for decades, having spent the last twenty years as the senior monetary policy correspondent for Market News International. In addition, he has been the Federal Reserve reporter for National Public Radio since 1990. He is also the author of Back from the Brink: The Greenspan Years and in 1995 the New York Times profiled himin an article entitled “The Beckner Effect,” referring to the fact that his byline can move markets. I used to work with Steve at Market News International and asked him to share his views on this week’s action by the Fed.

Mark Hemingway:Why do you think the Fed’s decision to cut the funds rate 50 basis points was surprising?

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Steve Beckner: Well, it was surprising in terms of the market expectations. The futures market had placed the odds of a 50 basis point cut considerably lower than that of a 25 basis point. But I also wrote that it was not a total shock. I had written that there was a strong case to be made for a half a percentage point cut but there were some offsetting considerations. Namely, if you’re the Fed do you want to look panicky? Do you want to look like you’re becoming too nonchalant or apathetic about risks of inflation? So it was a difficult choice, but the 50 basis point cut that they did — while it was greater than expected, was not totally surprising given the way they framed it.

Hemingway:How did the Fed “frame” the rate cut?

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Beckner: If they’d only cut 25 basis points, I would have expected them to adopt an easing bias, and by that I mean the Fed would show a clear tilt toward further rate cuts in the accompanying Federal Open Market Committee statement explaining the Fed’s action. But they cut 50 basis points and they didn’t have an easing bias accompanying it. In other words, I wouldn’t say it was a neutral statement but it did not contain the kind of language that Fed watchers would describe as an easing bias. It was not an obvious leaning toward further rate cuts. Now they certainly left the door open to further rate cuts but they didn’t betray any sort of predisposition in that direction. So I thought that was interesting. I think that probably represents a compromise between those on the Federal Open Market Committee who wanted bold action and those who were more uncertain about how much easing is really needed on top of all of the liquidity measures they had taken.

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Hemingway:The previous Federal Open Market Committee statement on August 17 noted that “downside risks to growth have increased appreciably.” This week’s statement didn’t repeat that language. Does this mean Fed is more bullish on the economy despite the credit problems?

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Beckner:Again, the fact that they did not include that downside risk statement that was in the August 17 statement, that to me shows the absence of a clear easing bias. If they had wanted to indicate that not only are we cutting rates today but we’re probably going to have to cut rates further, they would have said something like that. As you know, the last paragraph of the Federal Open Market Committee statement is the key policy paragraph. That’s where they put their bias if there’s going to be any bias. Up through the August 7 Federal Open Market Committee meeting, they had said inflation is their predominant policy concern. So then we go to August 17, and the Fed issues a special statement after they began injecting liquidity in response to problems in the credit markets. They say that downside risks had increased appreciably. And then in Tuesday’s statement, neither inflation nor downside risks are in there as a main focus of policy. So they went from a tightening bias on August 7th to a clear, very emphatic easing bias on August 17, to something noncommittal yesterday.

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Hemingway: What do you make of the change?

Beckner: That’s significant. And I think it reflects a couple of things. It may reflect a degree of confidence in the economy’s ability to rebound. But it also just reflects a good deal of uncertainty about what’s going to come and what will need to be done and I also think it reflects some disagreement on the committee. Bernanke was able to cobble together a consensus for a 50-basis-point rate cut [Tuesday] but was not able to simultaneously get a consensus for an easing bias — a commitment to or a strong suggestion that they would be doing more rate cuts.

Hemingway: Do you think the Fed could have avoided problems in the credit markets if they had cut the federal funds rate earlier? Or was there no way to diffuse the ticking time bomb in the subprime mortgage markets?

Beckner:I think the subprime problems were kind of baked in the cake. If they’d been really anticipatory and preemptive I suppose you could argue that if they had started easing earlier this year as a number of people were urging them to do, then it might have prevented some of the delinquencies and defaults and foreclosures and so forth. Maybe things wouldn’t have deteriorated quite as badly, but as we now know there was so much rot in the subprime market. So much of the rot was spreading into bank affiliates and portfolios of hedge funds and the like that I think it would have been hard to contain just purely by monetary means.

Hemingway: How do you see the rate cut affecting housing markets?

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Beckner:Well, I’m not an economic forecaster so I’m not smart enough to know the answer to that question. But it has lead to commensurate reductions in the prime rate and in turn will lead to reductions in adjustable rate mortgage payments. Mortgages that were due to reset will reset less high than they would have otherwise. So presumably it will be helpful. There’s such a huge inventory of unsold homes on the market and it’s going to take time to work through.

Hemingway:Does this rate cut mean that they view inflation as less of a threat than they did previously?

Beckner: In the long run, no. I think this is a temporary, emergency kind of policy response. As they said in rate announcement, there are remaining inflation concerns that they are going to be monitoring carefully; that this was a sort of a risk management approach to policy where for the time being they felt they had to respond to the downside risks and temporarily set aside inflation as their predominant policy concern, as they had previously been saying. And thankfully the Fed has enough of a reservoir of credibility — having demonstrated their willingness to fight inflation in the past — that they have the leeway to lean against these economic headwinds for the time being and get back to fighting inflation later once the markets and once the economy has stabilized. I think that’s the strategy. But certainly they have not abandoned their concern about inflation and inflation expectations — by no means have they done that.

Beckner:I’m a great admirer of Greenspan and got to know him pretty well over the years of covering him. I have to say I’ve been a little surprised. Paul Volcker — his predecessor — was mum about all these things for years after he left office. Greenspan is a guy who, despite his age, is very much involved as an economist and economic forecaster. Even before his book came out, I was surprised by his outspokenness. But as he said in one of his recent interviews: how am I going to pursue my chosen profession if I can’t go out and speak about these things? Greenspan has kind of broken the mold.

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